I. INTRODUCTION
II. THE RISE--YUKOS IN THE ERA OF COWBOY CAPITALISM
A. The Yeltsin Period--1990 to 1999
B. The Putin Period--2000 to 2008
III. THE FALL--EXPROPRIATION BY LITIGATION
IV. THE AFTERMATH--LITIGATION EVERYWHERE
A. Russian Claims on Foreign People and Property
B. Attacking the Yukos Transactions in National Courts
C. International Adjudication
V. IMPLICATIONS FOR THE GLOBAL ECONOMIC ORDER
VI. CONCLUSION

I. INTRODUCTION

The rise, fall, and death agony of the Yukos conglomerate have all
the elements of great literature. The tale features strong
personalities, sudden twists of fate, and profound clashes of principle.
The arc of the plot tracks Russia's deepest struggles in the two
decades since the demise of the Soviet Union and Soviet Communism. Real
individuals have suffered, one dying horribly in prison. The events have
inspired books and movies, and the story is not close to ending. (1)

This article does not have literary aspirations, but it does press
the importance of the Yukos affair as a window into contemporary Russia
and, more generally, modern efforts to impose order on the world
economy. It focuses not on the human drama of the story, great though it
is, but rather on the episode's significance in the ongoing
struggle over economic freedom and state sovereignty. Most importantly,
the Yukos story indicates the limits to the international rule of law.

In a nutshell, the rise and fall of Yukos illuminates four
narratives about the modern world economy. First, it exposes the
challenges--some might say insuperable barriers--to creation of a
liberal society on Russian soil. Second, it shows the deep problems with
top-down law reform in societies undergoing rapid and wrenching
political, economic and social change. Third, it demonstrates how
renationalization works in a particularly high-stakes context. Finally,
it reveals the capabilities and limits of international dispute
settlement through courts, arbitration, and diplomacy when confronting
profound conflicts between private rights and fiercely guarded national
interests.

As for the first point, one must carefully distinguish liberalism
from democracy. A democratic society gives the population power and
influence through effective mechanisms that translate the popular will
into government policy. Liberalism entails the maintenance of
institutions, both public and private, that check government power and
open up a space for private transactions and expression. Russia since
the fall of Communism has enjoyed a robust if imperfect democracy. By
every conceivable indicator, President Putin enjoys widespread popular
support, with his actions against Yukos in particular bolstering his
approval. But democracy does not necessarily lead to constraining the
state, as the Yukos affair demonstrates. The voice of the polis can call
out for and cheer on the destruction of over-mighty private actors: In
Russia, it did. (2)

Law reform was a worldwide growth industry in the 1990s, the era
that spawned the Yukos empire. The transition from totalitarian and
authoritarian states with government monopolies over economic activity
to something that might resemble liberal democracy inspired many to look
to law as the midwife of a new order. Foreign specialists, myself
included, flocked into the former Warsaw Pact countries in hopes of
building new institutions, with law as the bricks and mortar. But for
many of the reasons that liberalism did not take to Russian soil, legal
reform all too often became a tool for expanding, rather than
constraining, state power. The Yukos story is an exemplary tale of the
perversion of legal instruments to empower arbitrary and exploitative
bureaucrats to destroy private wealth. It also suggests something more
general about the limits of law in shaping social change.

On a technical level, Yukos provides a textbook example of how
formal legal requirements, in particular tax law, can lend themselves to
a program of renationalization of the commanding heights of the economy.
Each element of the case that the Russian authorities brought against
the company, in isolation, had an air of plausibility if not
inevitability. Yet, once assembled as a whole, the case seemed
preposterous. The government pursued two profoundly differently goals
simultaneously, maintaining a veneer of legality while communicating
clearly to the private sector that the state could act ruthlessly
whenever it wished. At the end of the day, Yukos ceased to exist as a
legal entity, a great energy empire ended up in government hands, and
the Yukos shareholders (many of whom were foreign portfolio investors,
not oligarchs and their minions) received nothing in return. In style if
not in substance, these events resemble Falangist Spain's
destruction of Barcelona Traction, a chestnut of international
investment law. (3)

Finally, the death throes of Yukos have spawned an extraordinary
array of litigation in many national and international forums. More than
a billion dollars in liquid assets resided outside Russia at the time of
government's attack on the firm. Much of this became a war chest to
fund lawsuits and arbitrations. Although the company has enjoyed
considerable success in these ventures, the main purpose of the
litigation seems to have been to clarify the extent of the Russian
government's audacity and impropriety, with the possibility of a
global settlement in the background. To date, however, the government
has defended itself fiercely, if not always successfully.

I employ all these narratives in the course of telling the Yukos
story. This article begins with a brief account of the origins of Yukos
and its rise to become the largest Russian energy company. The
beginnings were sordid, and along the way abuses of corporate governance undoubtedly occurred, but the entity that entered the twenty-first
century aspired to provide a new model of transparency and corporate
probity for Russian businesses. The article puts the early years of
Yukos in the context of the wild and contradictory period of
Yeltsin's presidency, a time viewed as inspiring by many in the
West and as disastrous by most Russians. It pays especially close
attention to the role of U.S. technical advisers, in particular those
who contributed to the design of the tax system that became the
instrument of Yukos's destruction.

The next section of this article describes Yukos's destruction
in some detail, concentrating on the role of Russian courts in ratifying
and enforcing the government's program of seizing the
company's most productive assets. It follows with an account of the
multijurisdictional and multinational litigation that ensued. It
concludes with a review of the lessons learned from the affair, focusing
on the potential of international law to mediate between private
economic power and state interests. At the end of the day, the episode
teaches us that the rule of law, both domestic and international, is a
more fragile and uncertain enterprise than the optimistic architects of
the Washington consensus may have believed two decades ago.

II. THE RISE--YUKOS IN THE ERA OF COWBOY CAPITALISM

Any historical narrative of Russian events must frame them with
presidential terms. This is not because Russian Presidents necessarily
have any greater discretion or influence than political leaders in other
countries, but rather because Presidents serve as the nexus of debate
and administrative decisionmaking. It helps that the turnover of leaders
was abrupt and specific, with Putin following Yeltsin just as the 1990s
came to an end. The arc of Yukos's ascent cuts across both regimes,
but took different shape in each. The legal background, especially the
law reform project, also differed significantly during the two periods.

A. The Yeltsin Period--1990 to 1999

The first part of the story involves the 1990s, a time when Russia
discarded the Soviet Union and embarked by fits and starts on the path
of reform. Hordes of international advisors descended on Moscow and
received an intermittently attentive audience. Many in the West, first
and foremost the leaders of the United States, purported to be impressed
with these changes and gave them their blessings as well as significant
material support. Ordinary Russians, however, became increasingly
disillusioned with a transformation that seemed to produce economic
chaos, immiserization and injustice, rather than a better life. The
tension between the hopes for reform and the actual practice of powerful
actors frames the events around the rise of Yukos.

To understand the pathway of reform in Russia, one must remember
the challenges presented by the Soviet legacy. The Soviet economy relied
on state ownership and management of nearly all productive activity,
using quantitative targets rather than prices to determine outcomes.
This system suppressed important information about performance and
encouraged widespread corruption and rent-seeking. Not only did Soviet
management ensure that the country could not compete internationally
(which in turn required autarchy to protect the economy from the outside
world), but it facilitated the accumulation of wealth and power among
middle-managers that subverted the supposed hierarchy of central command
and control. (4)

In theory, reform would entail overturning these structural
features. Assets would move from state to private ownership, markets
would emerge, and competition and price transparency would direct
economic activity towards its most productive possibilities. Lost in the
confusion was two profound constraints on the project: Many powerful
actors benefitted more from opacity rather than transparency, because
they could do better by stealing existing assets than by producing new
ones, and the institutions necessary to support transparent market transactions, especially strong and independent courts and a civil
society that could investigate and publicize abuses, did not exist. The
international advisers, drawn from the international financial
institutions (the International Monetary Fund, the World Bank, and the
Organization for Economic Cooperation and Development) and the
ministries of finance of the great Western powers, initially wielded
considerable influence because of the international debt burden that
Russia had inherited from the Soviet Union. But they mostly were deaf to
these institutional factors. As a result, privatization in Russia became
synonymous with kleptocracy. (5)

During the summer and fall of 1995, Boris Yeltsin, a hero abroad
but a dismaying and damaged figure in his homeland, faced the
consequences of this feckless reform. Most Russians viewed his
administration as disastrous, attributing the country's sharp drop
in economic output and widespread economic insecurity to the reforms and
perceiving its gains as concentrated largely in the hands of a small
number of opportunists and insiders. Polls suggested that Yeltsin had
lost almost all popular support and had essentially no chance of winning
re-election in 1996. (6) Dramatic steps were necessary if he was to
retain power.

The precise details of the arrangement that resulted remain
obscure, but the broad outlines are evident. The so-called oligarchs,
who had amassed wealth and power during the privatization process,
largely through banking and media companies, would throw their weight
behind Yeltsin. What this weight entailed, and whether the resulting
election was merely bent or an outright fraud, will always be a matter
of debate. What they received in return was access at a deep discount to
the most valuable assets remaining in state hands. They would obtain
these properties through the so-called loan for shares scheme, under
which the Russian state would borrow money from the oligarchs and
provide security worth many times the amount of the loans. Upon the
anticipated default on the loans, the lenders would take over
state-owned firms controlling vast natural resources. (7)

These events led to the creation of Yukos as a private company. The
transaction by which the government transferred this entity to a
consortium led by the Menatep Bank was one of the more prominent, indeed
notorious, of the loans-for-shares program. For starters, Menatep also
acted as the representative of the State Committee of Privatization, the
borrower/seller, and enjoyed an intimate relationship with the Russian
Ministry of Finance, which had significant minority interest in the
bank. Because of this clear conflict of interest, the possibility that
Russia would receive anything like a fair return seemed vanishingly
remote.

Other banks challenged Menatep's bid for Yukos, not because
these conflicts were illegal (other banks were doing similar things),
but because Menatep's creditworthiness was suspect. The transaction
nonetheless closed in December 1995 with the consortium acquiring 78
percent of Yukos's shares either directly or as collateral. (8) The
price paid indicated that Yukos's equity had a value of roughly
$450 million, while a public offering of the stock less than two years
later valued the firm at $9 billion. At this point Mikhail Khodorkovsky,
the oligarch who had put together and led Menatep, shifted the focus of
his activities to the energy company. (9)

Menatep borrowed much of the money needed to consummate this
transaction, pledging its shares in Yukos as collateral. Russia's
financial crisis in 1998 triggered a rearrangement of Yukos and its
assets, largely to defraud Menatep's creditors but also to squeeze
out minority investors in Yukos's most valuable holdings. First,
Menatep transferred its principal assets to a new company and then
destroyed the paper trail that documented the transfer. (10) Second, to
erase the value of the security for some of Menatep's debts to
foreign banks, Yukos's management hollowed out the company to
render its stock worthless. Yukos then consisted principally of its
majority stakes in three production companies, Yuganskneftegaz (YNG),
Tomskneft (TK), and Samaraneftegaz (SNG). The management orchestrated a
massive dilution of the ownership of these entities, resulting in
transfer of control to offshore shells, presumably beneficially owned by
them, at less than ten percent of actual value. (11) Foreign investors
with minority stakes in the production companies sued, but recovered
very little. (12) Once the holders of the security interests in Yukos
stock settled their claims for a small fraction of their value and the
minority investors in the production companies sold out, Yukos
retransferred control over YNG, TK and SNG back to itself. (13) By the
end of the 1990's, Yukos had become a holding company free from
much outside debt with full control over subsidiaries that held
enormously valuable oil and gas rights. Menatep correspondingly became a
passive shareholder rather than the nexus of Yukos's control and
management.

Parallel to the freebooting grabs of state assets, of which the
Yukos episode was prominent but hardly unique, there proceeded efforts
to build legal institutions that would put business transactions on a
more stable basis and, it was hoped, preclude the kinds of larceny that
the existing Russian regime seemed to encourage. Western, and particular
U.S., advisers, mostly academics, played a role in drafting many of
these laws, although the extent of their influence is debatable. (14)
Two of the law reform projects had a direct bearing on the Yukos affair,
namely the Joint Stock Company Law and the Tax Code.

The principal drafters of the Joint Stock Company Law were
Professor Bernard Black of Columbia and Stanford Law Schools and
Professor Renier Kraakman of Harvard Law School. These distinguished
academics sought to put corporate governance in Russia on a sounder
legal basis. They identified as the principal problems with current law
a history of insider self-dealing with respect to company assets and
weak legal institutions, courts in particular. Their solution was to
endow shareholders with strong rights to challenge transactions that
satisfied a broad, and perhaps elastic, definition of self-dealing. They
believed that clarity in the legal entitlement would overcome the
problem of weak courts. (15) The Russia legislature, or Duma, adopted
the statute in 1995. (16)

The path to comprehensive reform of the Russian tax system was not
as direct and the role of U.S. law professors not as high-profile as
with corporate governance. (17) Russia had adopted a variety of tax laws
during the early months of the Republic, some while it still was part of
the U.S.S.R. In the following years taxes proliferated, as well as
loopholes and exemptions. Discussions of folding this welter of
legislation into a unified tax code began as early as 1993. On the
Russian side, the most important figure pushing for adoption of a code
was Sergey D. Shatalov, a physicist who had been elected to the Russian
Supreme Soviet (the predecessor of the Duma) during the first wave of
reforms in 1990. (18) He was the principal architect of tax legislation
up to Yeltsin's dissolution of the Supreme Soviet in 1993. He then
served President Yeltsin as Deputy Minister of Finance, concentrating on
tax policy, from 1995 to 1998. Shortly after President Putin took office
in 2000, Shatalov rejoined the government as First Deputy Minister of
Finance, and has held the post of Deputy Minister since 2004. He will
feature in the next part of this article, dealing with Yukos's
fall.

In general terms, the foreign advisers advocated that Russia
simplify and rationalize its tax laws. They proposed consolidating taxes
into a valued added tax (VAT), a tax on business profits (profits tax),
a tax on individual income limited to a small fraction of the population
(income tax), and various excise taxes designed to discourage certain
behavior. More fundamentally, the advisers recommended that the Code
regulate the authority of sub-national units to levy taxes, cut back on
the draconian penalties for tax offenders, and formalize the lines of
administrative authority over, and judicial oversight of, the assessment
and collection process.

One thread of the discussions between the advisers and Russian
authorities was the role of formalism in the interpretation and
application in Russian tax law. The 1990s saw an explosion of
contractual and organizational forms in the private sector. This arose
partly in response to the lifting of the heavy hand of state management
of the economy, but mostly to conceal the nature of transactions and to
defeat the state requirements, taxation in particular, that survived.
The tax authorities had little experience with these new forms and had a
tendency to respond woodenly rather than creatively. The advisers wished
to supply the authorities with conceptual tools that would allow them to
react appropriately to these transactions while honoring the rule of
law. Shatalov in particular seemed to appreciate these suggestions.

An example may illustrate the problem. When a merchant sells a
product to a consumer, a VAT should impose a charge based on the price
paid by the buyer. A VAT normally does not apply, however, to payments
representing loan disbursements or repayments, because in either case
the change in cash on hand is exactly offset by a change in the payer
and payee's net debt owed. Russian VAT taxpayers sought to
manipulate these rules by accepting loans from consumers in an amount
equal to the sale price of a good, and then having the consumer cancel
the loan in return for receipt of the good. Initially, Russian
authorities responded to the challenge by arguing that the VAT should
apply to all transfers of loan proceeds as well to sales. When
confronted with the bizarre consequences of such a stance, in particular
the assessment of a significant surcharge on inflows of debt investments
from foreign sources, the authorities reconsidered, but had difficulty
coming up with a clear conceptual basis for levying a VAT on these
transactions.

From a U.S. perspective, at least two techniques exist to solve
this problem. First, because the loan and the transfer of the goods were
legally interdependent, in the sense that the parties agreed to one
transaction only because they agreed to the other, one could collapse
them into a single sale of goods for cash. (19) Alternatively, one could
treat the discharge of the debt as a payment for purposes of the VAT.
(20) Either move rests on a power of the tax authorities, supervised by
the courts, to recharacterize the transaction to align the private law
aspects with its tax incidents.

When the Russian tax authorities attacked these transactions, they
took the first route. The High Arbitrazh Court, the highest court with
jurisdiction over questions of tax law, agreed that the intent of the
parties, rather than the labels invoked in the documentation, would
determine the outcome. (21) Because the parties intended a sale of goods
for cash, the taxes applicable to such sales would apply. (22)

U.S. experts encouraged the drafters of the Tax Code to include
provisions that would provide a statutory basis for a limited power to
recharacterize transactions to achieve the intended results. While
Shatalov embraced this proposal, the Duma did not. Ultimately it adopted
language that became Article 11(1). This provision states:
"Institutions, concepts and terms of civil law, family law and
other branches of law used in this Code shall apply in the meaning in
which they are used in these branches of law unless otherwise provided
by this Code." (23) This meant that the tax authorities could not
invoke tax concepts or policy to determine the tax incidents of
transactions, but rather had to accept transactions as the civil
(private) law determined them. (24) The Duma simply did not trust the
tax authorities to wield discretion, and was willing to sacrifice tax
enforcement to prevent bureaucratic abuse. (25)

One particular area where private law and tax policy conflict is
transfer pricing. When separate legal entities with a common economic
interest, such as sibling companies controlled by a common parent,
transact, price is a matter of bookkeeping rather than a motivation for
the deal. Absent some kind of regulation, taxpayers will choose prices
that minimize taxes. Recognizing this problem, most tax regimes have
rules that explicitly authorize the tax authorities to restate prices
where transactions are not arms-length. The U.S. advisers urged Russia
also to incorporate transfer pricing authority into the Tax Code.

The provision that resulted, Article 40 of the Tax Code, broadly
conformed to what the foreign advisers recommended. (26) It allows the
authorities to challenge the prices of transactions between related
parties in cases where the contract price deviates by more than twenty
percent from market prices. The provision contains two interpretive
ambiguities that might have limited its usefulness: It does not make
absolutely clear how its recalculation rules operate when there exist no
comparable arms-length market transactions, and it does not expressly
provide for price adjustments that benefit a taxpayer, as in the case
where increasing one party's profit lowers the counterparty's
gains. (27) The provision does indicate, however, that the Duma
anticipated transfer pricing issues and sought to provide the tax
authorities with the tools needed to deal with them.

After extensive debates and many revisions of the government's
proposal, the Duma enacted Part I of the Tax Code in July 1998. (28)
This law did not deal with particular taxes, but rather enacts general
and transubstantive rules of procedure, interpretation, and delegation
of authority. Thus it provides rules of administration, assessment and
enforcement for all taxes.

Part II of the Tax Code, which provides a comprehensive set of
rules for substantive Russian taxes, proceeded apace. At the time of
President's Yeltsin's resignation at the end of 1999, much
progress had been made. Final enactment, however, did not come until
after Vladimir Putin had assumed power.

Outside of the Tax Code, another tax-related issue relevant to
Yukos was the creation of so-called domestic tax havens. These came in
two flavors. First, a 1992 law allowed "closed
administrative-territorial entities" (ZATO is the Russian acronym)
to control fully all taxes collected within their territory, including
the authority to rebate the taxes to firms that made contributions to
the ZATO's budget. ZATOs were former closed cities engaged
primarily in secret national security work, all of which had experienced
economic collapse with the end of the Soviet Union. (29) Second, Moscow
responded to the problem of ethnically distinct regions, mostly in the
middle of the country and the Caucasus, that threatened to break away
from the center by granting similar local control over their fiscal
powers. (30) All the private energy companies, including Yukos, took
advantage of the domestic tax shelters by sourcing profits to thinly
capitalized entities located in domestic tax havens. (31)

By 1999, it had become apparent that these tax privileges were a
highly wasteful means of encouraging economic development in the
targeted areas. Competition among tax havens meant that outside firms
were able to obtain significant tax benefits at the cost of only modest
contributions to the local budget. The Duma at first sought to rein in the ZATOs, adopting a law in 1999 that limited benefits to firms that
had a substantial portion of its capital and work force on the territory
of the ZATO in question. Energy companies managed to comply with the new
requirements by setting up trading companies that did not need
significant amounts of capital or employees to operate. Finally the Duma
abolished ZATO tax exemptions altogether, commencing in 2000. Reform of
the regional tax shelters, however, awaited later legislation. (32)

B. The Putin Period--2000 to 2008

Although in evident declining health, Yeltsin still shocked the
world when he announced that he would step down as President at the end
of 1999 in favor of Putin, his recently designated successor. (33) Putin
immediately began to establish a new direction in Russian domestic
policy, based on the concepts of stability and consolidation of the
achievements of the previous decade. He made it clear that he would take
no action against those in Yeltsin's entourage who had become rich
by feasting on the Russian state, but also indicated that henceforth the
new class of Russian super-rich would be expected to give back to the
society that had fed their wealth. In the most general terms, he held
out the prospect of greater order without Soviet-style repression. (34)

At first Yukos responded to the new regime positively. Having
rather outrageously shed claims by others on its assets, either through
loans or by minority membership in the production companies, it sought
to repackage itself as a new, westernized firm that aspired to be a
paragon of transparency and good corporate governance. It tried to draw
a line through its past, and to enter the new decade as a model for a
new, more civilized form of Russian capitalism. (35) At least
superficially, this married nicely with the Putin administration's
message of promoting capitalism, but without the robber barons.

During the first few years of the Putin period, Yukos continued to
grow and thrive. In 2002 it acquired Rospan, a natural gas company, with
Kremlin backing greasing the way. (36) Then, in the spring of 2003, came
the firm's apotheosis. It contracted to acquire Sibneft, another
energy giant that also arose out of the loans-for-shares episode. The
merger was intended to create the dominant energy company in Russia as
well as one of the largest in the world. It closed in October, 2003,
just as the storm was about to break.

During the fall of 2003, as Yukos danced ever closer to the
precipice, it entered into talks with several western oil majors about a
possible combination. By integrating Yukos within a western company, not
only would its owners have created what effectively would have been the
world's largest energy company, but the marriage of private
ownership and Russian energy would have become unbreakable. The market
seemed to like all this, as shortly before Khodorkovsky's arrest
the implied market valuation of the firm was in the neighborhood of $43
billion. (37)

During this first phase of the Putin period, law reform proceeded
apace. For purposes of the Yukos story, the most significant event was
the enactment of Part II of the Tax Code. This legislation contains
detailed rules defining the tax base and taxpayers. In large part it
rationalized and clarified the preexisting substantive law of taxation.

Another significant development in tax legislation was first the
policing, and then the elimination, of so called domestic tax shelters.
As noted above, the privileges accorded ZATOs were wound down at the end
of the 1990s. The Duma turned to the designated regions during the Putin
years, and ultimately eliminated these privileges entirely as of 2004.
(38) With these changes, the incentive to use transfer prices so as to
locate all profits inside sales companies would disappear, because
domestic firms would face essentially the same tax rules regardless of
their location.

As of mid-2003, then, Russia seemed reconciled to the excesses of
the 1990s, although also determined not to permit their repetition.
Optimists hoped that the Putin regime would accept the new economic
order, characterized by significant concentration of ownership balanced
by fair contributions to state and society, mediated largely by the tax
system. Perhaps nothing gave advocates of the rule of law in Russia
greater hope than the restoration of Valery Zorkin as chairman of the
Constitutional Court in February 2003. Zorkin, the first head of what in
some sense is Russia's highest legal body, had lost that position
(but not his place on the Court itself) following Yeltsin's
overthrow of the Court and the then Duma in 1993. His restoration as
chair seemed to capture a mood of stability based on a shaky, but
growing, legal order.

III. THE FALL--EXPROPRIATION BY LITIGATION

Russian history can be told largely as a series of false dawns
followed by crushed hopes. 2003 was no exception. Whatever the odds were
at the beginning of the year that Russia under Putin might nurture an
emerging liberal order based on property rights, social solidarity, and
a government committed to the maintenance of ordered freedom, within
twelve months these prospects seemed to be receding rapidly into the
distance. The Yukos affair crystallized the turnaround in hopes for
liberalism.

Much of what captured the popular imagination in this story
concerns the fate of Mikhail Khodorkovsky, the company's head, and
Platon Lebedev, a leading figure in Menatep, who were arrested in
October and July 2003, respectively. (39) Without belittling the
personal fate of these figures, along with that of other Yukos officials
arrested and imprisoned by Russia, the heart of the story involves what
happened to the company itself. The cases against Khodorkovsky and
Lebedev doubtlessly involved abuses, as even the remarkably gun-shy
European Court of Human Rights has acknowledged. (40) But, from an
international perspective, as least as important as the mistreatment of
Russian nationals through the criminal law is the destruction of
property, much of it foreign investment, through a spectacular
perversion of the tax system. The attack on Yukos itself not only
affected foreigners, many of whom enjoy traditional protection under
international law, but indicated a profound unreliability about the core
governmental institutions on which private economic activity rests.

In theory, the Russian government might have sought simply to undo
the privatization of Yukos. As noted above, the transaction involved
deep conflicts of interest, resulting in robbing the state of a valuable
asset. But to take on the loans-for-shares affair directly would
implicate Yeltsin, which in turn would cast a shadow over Putin,
Yeltsin's creature. An alternative theory was necessary to justify
destroying Yukos without undoing the parallel privatizations of that
period.

The government found its answer in tax enforcement. The criminal
charges against Khodorkovsky included participation in corporate tax
evasion. In December 2003 the tax authorities announced that it would
re-audit Yukos for the tax year 2000, and three weeks later announced
that they had uncovered underpayment of $2.27 billion in taxes. The
following April the authorities imposed a total assessment of $3.4
billion and simultaneously went to court to obtain enforcement. The next
day the court issued a freeze order forbidding the company from
alienating or encumbering its property. (41)

The legal theory behind the new assessment comprised elements that,
standing alone, had some plausibility, but, once assembled, defied
credibility. (42) In essence, the company followed industry practice in
limiting the profits-tax exposure of its production companies by running
sales through trading companies located in domestic tax havens. (43) The
trading companies typically were not owned directly by Yukos, although
Yukos managed most of their activities through a series of agency
relationships. The production companies sold their output to the trading
companies, which in turn either traded among themselves or sold to an
independent broker, in most cases a foreign one. The production
companies sought to avoid any profits tax by selling the product at
cost, while the trading companies took advantage of the profits-tax
exemption provided by the current domestic tax haven legislation. Yukos,
as a holding company, owed nothing, because it was not a party to any of
these transactions. Significantly, none of this affected the net VAT
liability for these sales. The tax haven exemptions did not apply to the
VAT, and Russia's law, like that of every VAT in the world, used a
zero rate for exports. (44)

A numerical example can illustrate the stakes. Suppose YNG spent
100 to produce oil that had an objective market price (putting aside how
one might arrive at this figure) of 200. Further assume that half of
this cost involved the purchase of inputs subject to a twenty percent
VAT, and that the profits tax applicable to YNG was forty percent of its
net income. If YNG were to sell the oil to a trading company for 100,
and the trading company in turn were to sell the oil to a foreign
customer for 250, YNG and the trading company would both pay a profits
tax of zero. YNG would have no profit, and the trading company would
have enjoyed an exemption for its nominal gain of 150. YNG initially
would have paid a VAT of 10 on its inputs through surcharges imposed by
its suppliers, and then would have collected a surcharge of 20 on the
sale to the trading company, with a net payment to the government of 10
after taking advantage of the credit due for its input VAT. Upon export,
the trading company would have gotten a refund for its input VAT of 20.
Overall, the government would have collected no profits tax and no net
VAT.

A plausible line of attack by the tax authorities would have been
to insist, pursuant to transfer pricing rules, that YNG and the trading
company be taxed as if YNG received 200 for the oil. As a result, at a
hypothetical profits tax rate of forty percent, YNG would face a
liability of 40 on its gain of 100. This adjustment would not change the
amount of VAT collected, however, as any upward increase on the VAT
imposed on the sale by YNG to the trading company would be exactly
offset by a credit received by the trading company on the export sale.

In the Yukos assessment, the Tax Ministry did not invoke this
logical and obvious strategy. Instead, it constructed an unprecedented
and one-off theory that doubled the imputed liability and assigned it to
Yukos rather than YNG. The Tax Ministry asserted that, for every tax
purpose but one, all of the trading company transactions should be
attributed to Yukos. Yukos, not located in a domestic tax haven, thus
would pay a profits tax on the difference between the low price paid the
production companies and the arm's-length price paid by foreign
brokers. But, because the production companies were the owners of
record, Yukos never had filed on its own behalf for application of the
zero VAT rate to the export sales. This failure to file barred Yukos
from claiming the zero rate, thus obligating it to treat all the sales
as if they were to domestic customers and thus subject to a full VAT.
(45)

In effect, the Ministry simultaneously (1) insisted on a strong
substance-over-form story to attribute profits, formally earned by the
production companies and the trading companies, and the resulting
profits tax, to Yukos, and (2) insisted on an extremely formalistic argument as to why Yukos had to pay a full VAT on goods that
indisputably had been exported and thus qualified for the zero rate. The
double punch had an enormous impact on the total owed: The VAT
assessment, as well as interest and penalties associated with the
nonpayment, was a large portion of the total liability for 2000. Taking
into account the additional assessments for 2001 through 2003, all
levied in the run up to the December auction of the company's most
valuable asset, the VAT bill substantially exceeded that related to the
profits tax. (46)

Because Article 11(1) of the Tax Code required the tax authorities
to tax transactions in accordance with their civil law characteristics,
the tax authorities needed a civil law argument to justify attributing
all of the trading company activities (other than the filing of
documents for the zero VAT rate) to Yukos. The one chosen was so weak
that the Russian government abandoned it when later confronted with
international arbitration, but it did the trick at the time. The Tax
Ministry noted that Article 209 of the Civil Code describes what powers
the owner of property exercises. (47) It argued, and the courts agreed,
that this provision implied that anyone who possesses these powers must
be an owner. Yukos, through consignment contracts and other agency
agreements, could carry out sales on behalf of the trading companies,
and thus possessed these powers. Ergo, it must have been the owner.

If all the actions of the trading companies were attributable to
Yukos, what about the documentation presented by those companies to
justify a zero VAT rate for export sales? The documents, it turned out,
had a fatal deficiency: They claimed that the trading companies, and not
Yukos, did the exporting. Because the documents did not name Yukos as
the owner, they failed to meet the statutory requirements for receiving
a zero rate. (48)

Even a modest knowledge of how civil law works would suffice to
expose the absurdity of the tax authorities' argument.
Russia's Civil Code, like that of any country with a comparable
body of private law, recognizes an array of agency relationships,
pursuant to which a non-owner can exercise powers on behalf of an owner.
The delegation or assignment of these powers does not change the fact of
ownership. Article 209 does not identify who should be considered an
owner. Rather, it specifies, once it is determined who is an owner, what
that owner can do.

The Civil Code does deal with phony transactions, where the
asserted form does not reflect reality. Article 170 treats as void
transactions "made only for appearances without the intent to bring
about the corresponding legal consequences" or "made for the
purpose of hiding another transaction." (49) The authorities might
have tried to argue that the transactions between the production
companies and the sales companies lacked substance, because the parties
never intended the trading companies to act as buyers or sellers of oil.
Yukos doubtlessly would have responded that the companies did intend to
carry out these transactions, and that trading for one's account
does not require either significant hardware or numerous personnel
(unlike, say, refining crude oil). Perhaps because this response seems
compelling, the authorities never invoked Article 170. (50)

The proceedings against Yukos arose while Shatalov was the leading
tax official in the Russian government. Some persons associated with
Yukos accused him of orchestrating the case, although direct evidence of
this does not exist. (51) Given his earlier interest in
substance-over-form doctrines developed in the United States, and his
dissatisfaction with the legislative politics that led to the
incorporation of Article 11(1) in the Tax Code, it would not be
surprising if he seized on the opportunity presented by a political
mandate from above to destroy Khodorkovsky to move tax law in what he
perceived as a sound direction. It also would not be inconsistent with
his background, which included great experience with tax policy and
enormous conceptual intelligence but also no formal training in civil
law, for him to approve a superficially plausible legal theory that
lacked any substantial basis in the Civil Code. At the end of the day,
however, one can only speculate about these matters. (52)

Not satisfied with a dubious legal theory, the tax authorities
employed ferocious tactics to undermine any judicial resistance to
enforcement of their assessment. One judge who tried to overturn the
asset freeze was removed from the case, and then fired; another judge
who fully backed the government's case won an award, and then
promotion. The company's legal department, in turmoil due to the
arrests of Yukos personnel, was given exceptionally short deadlines to
respond to the government's case and no effective opportunity to
review the government's evidence. Most extraordinarily, the
government relied on the asset freeze to bar any payment of the
assessment. Between its Sibneft stock and Menatep's holdings of
Yukos stock, there existed more than enough liquid assets to satisfy the
government's claim. But the government insisted on payment only in
cash, not in property, and used the freeze to bar Yukos from converting
its liquid assets into cash.

Throughout the summer of 2004, the government rang up victory after
victory in the Russian courts. In July it identified its real objective
by announcing its intention to sell off Yukos's YNG stock. YNG
owned the majority of the production under Yukos's control, so
severing it from Yukos would effectively cripple the company.

During the fall of 2004, as the deadline for the YNG auction
approached, the government upped the ante by bringing new assessments
for the 2001 through 2003 tax years. (53) Ultimately the total amount
claimed came to more than $24 billion, a figure that exceeded what even
a fair sale of YNG could bring in. The auction of YNG in December 2004,
however, failed to satisfy even minimal standards of fairness. Based on
proven reserves and its recent history of production, YNG probably was
worth somewhere between $15 and $20 billion. Baikal Finance Group (BFG),
a shell company created two weeks before the auction, put in the only
bid above the reservation price and acquired YNG for $9.35 billion.
Rosneft, a state-owned energy company, then acquired YNG from BFG with
financing provided by the China National Petroleum Corporation. (54)

Stripped of its most valuable asset and crippled by the remaining
tax assessment, Yukos limped along a little longer. Beginning in 2005,
Rosneft filed several suits against Yukos for nonpayment for oil
purchases as well as for YNG's tax liabilities. Bankruptcy
proceedings began in March 2006. Rosneft and the Tax Ministry rejected a
proposed restructuring in July, and final liquidation of the company
occurred in the fall of 2007, with Rosneft receiving most of the
remaining assets and Promnefstroy, a former Rosneft subsidiary,
obtaining a claim to Yukos's Dutch subsidiary Yukos Finance B.V.
Remarkably, once the liquidation got under way, YNG's tax
liabilities somehow disappeared. At the end of the day, all of the
assets of Russia's largest energy company had passed into the hands
of a state-owned holding company, without any compensation to its owners
or any outlay by the Russian state. (55)

Throughout the debacle, the lower courts in Russia played a crucial
role in confirming the government's theories and mechanisms, most
importantly including the outrageous tax assessment for 2000, the asset
freeze, and the auction of YNG. Interestingly, however, the highest
courts in the system, while not risking any intervention, mostly kept
their distance from the mess. The High Arbitrazh Court limited its
involvement to a determination, made long after the YNG auction, that
the three-year statute of limitations applicable to the collection of
penalties (but not the underlying assessment) did not apply to
Yukos's 2000 tax year because of its supposed noncooperation with
the audit. (56) The Constitutional Court first ducked this question on a
procedural ground, and then, over the dissent of three members of the
Court, reached the same conclusion as did the High Arbitrazh Court. (57)
Then in 2006 the Plenum of the High Arbitrazh Court issued general
guidelines to the lower courts on the interpretation of tax law that, in
general, disapproved the kinds of arguments that had worked in Yukos.
(58) Overall, the leading courts, while recognizing their powerlessness
to stop a politically determined outcome, sought to erect barriers
against infection of the legal system with essentially unreviewable
government discretion to reassess taxes and seize taxpayer assets.

Whatever the diffidence expressed by some figures in the legal
system, however, the brute facts of the case remain. What in 2003 was a
political and personal dispute with the leading figures of Yukos became,
in 2004, an all-out assault on the company itself. The Russian
government, using a groundbreaking legal theory and intimidation of the
reviewing courts, invented an enormous tax liability and then barred the
company from paying it. This allowed the government to take over one of
the largest production companies in Russia at virtually no cost, meaning
without any compensation to Yukos or its shareholders. It was not enough
for the Kremlin to destroy Khodorkovsky and his wealth: It also wiped
out all outside investment in Khodorkovsky's enterprises.

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